The PEG has no sound investment basis. The reason is simply because there is nothing to justify why a stock should trade at a PE that reflects its growth rate. A PE as with any rating has to consider the risk attached to a stock for start. This is not required by the PEG.

If two stocks both grow earnings at 20% and one is rated with a PE of 12 and the other at 25, the PEG suggests that the one is inexpensive and the other expensive. This is nonsense. Each company will have different fundamentals leading to a different risk rating in the form of its beta for a start. So this alone destroys the PEG.

In fact the 12 PE stock may even be expensive while the 25 PE stock may be in a good buying area.

While I agree with the fact that stocks are not equal, I would disagree that the PEG is worthless.

First, if two stocks are growing earnings at the same 20% clip and one has a pe of 12 and the other stock has a pe of 25 then the stock that has the lower pe will offer you a greater reward vs risk ratio as compared to the risk free rate of return known in my finance classes as k. However this does not take into account the fundamentals of the business. It's not suspose to. You need to scour the 10k's and Q's to determine if it is a solid company. So the reason you think the peg is worthless is because your not using it correctly. It is the last measure to look at after you have found the right company. The pe of 25 could be less expensive if the company has a much greater chance to maintain the 20% growth. But if both companies have the same likelyhood to earn 20% growth then the stock trading at a pe of 12 should always be considered undervalued regardless of beta. Beta has nothing to do with a company's fundamentals but rather with the volatility of the stock price in correlation to the movement of the market. You seemed to tie market timing with fundmental analysis. That is comparing apple to oranges.

To conclude, The peg has its limitations butif used properly it can be very effective to determine if a stock is undervalued, overvalued, or fairly valued.I realize this issue is much more complex but I wanted to keep this short. So basically remember use the peg only to determine the right price and not the right company.

Sincerely,

GSJ

To conclude the PEG has limitations but if used properly can be a very effective tool and certainly shouldn't be thrown out to the trash.

I think you had better revisit your finance lessons. The risk free return used is only part of the equation that will calculate the cost of capital demanded. The pivot being the beta number. Providing the betas for both companies are identical, then there is of course a probability that the PE ratio used may end up being the same. But that is only the start. Next, the PE ratio has to be calculated.

In this case, depending what model is used to calculate the PE ratio, such as a two or three stage, and providing payout ratios and the growth rates are identical, then we will end up with a common PE ratio. This seldom occurs in my experience.

The result is that a PE ratio used will possibly end up being identical to a company's growth rate, but again, this more coincidence than probability, especially when it comes to cyclical commodity stocks.Furthermore, the PE is usually lower or higher than the growth rate. Using the PEG creates a situation where an investor will have an endless "value" situation, or an overvalued situation - misleading investment decisions.

I would like to add that the PE ratio is rigid and while it can offer reasonably useful valuation of most stocks, it is not at all an complete method, hence its demise, especially over the last few years on Wall street given the liberation of valuation accompanying the tech "revolution".

I would have to agree with GSJ. I don't understand your reliance on beta. Could you give a simple hand waving arguement on how a stock's valuation is related to beta? What do you mean by an "endless 'value' situation"? What do you mean when you say "the PE ratio is rigid"?

I will grant that the PEG is simple and should not be used by itself. You should also look at a company's debt, cash, ROE and other numbers. In the end, you need to know whether the price of a company is good. The price per share is meaningless because stocks can split. How do you know what's a good price? The PEG looks at price in comparison to current and future earnings. In essence, the PEG says that the value of a company is related to how much the company made and will make in the future.

I don't trust the valuations of the tech revolution. They have not had the test of time. They seem to be based on psychology, rather than firm hard facts. The tech valuations are only a couple years old. I will feel more comfortable with them if they last 10 or 20 years.

A stock's valuation is reliant on beta because it is the only way to quantify its risk, and as of date is the accepted technique used in modern investment finance, in other words Wall street. Briefly, beta, which is a dynamic measure, is determined by the type of business, degree of operating leverage and financial leverage.Inherent in this are the financial fundamentals extracted from the Form 10's mentioned by GSJ.

Now whether this fits in with the PEG measure I cannot help. I am just stating the way it is.

When I say "endless value situation or overvalued situation" I refer to the conclusion, that as a result of the method a PE is determined, a stock can be allocated a PE lower or higher than its earnings growth rate by the market. Therefore if the PEG is used, then a stock can appear to be perpetually inexpensive or perpetually expensive. The upshot being that using the PEG will continually cause erroneous decisions to be made relative to intentions. A PEG can indicate a stock is "cheap" when it is actually overpriced, and vice versa.

Whether you or I or anyone else trusts the tech revolution or not is not important or has any affect on the matter at hand. The way stock valuation is determined, whether using PE, PS or Cash Flow methods has been decided.

I see that the "fool methods" encourage "five year predictions." I am glad that the fools believe they are able to predict five years into the future. Even the top rated analysts on Wall street will not venture past 2 years and updates based on guidance from the company concerned is frequently undertaken and sought. Historically, predictions have had little more success than basing it on the current trend over a selected quarterly based moving average.

The tech valuations are fully justified. PE ratios which are published have in most cases little to do with being correct. The core reason is because companies in the high growth phase have significant charges which are applied to the income statement. These have to be adjusted for. This is not done by Nasdaq, NYSE or any newspaper. So what you see and use to input a measure such as the PEG is severely skewed.

As for valuation methods standing "the test of time" - they have been around for many years. In fact the father of security analysis, the late Benjamin Graham, wholeheartedly embraced the emergence of modern portfolio theory and quantitative analysis. It not only incorporated his work, but added another dimension.

I feel that there is some areas of investment valuation that you might have a leg up on me. However I am confident in my abilities and disagree with a couple of the things you mentioned.

I still don't see how you can measure a company in fundamental analysis using beta. Peter Lynch, Buffet, and John Neff never mention it. As for Graham I have to plead ignorance but I'm glad you mentioned him since I am a big fan of his philosophy as is Buffet. Although he uses a lot of Phillip Fisher to. And I know Buffet doesn't use it. But We should agree to disagree on this. Although one biotech company I investigated had a beta of .56 and is a swinging jenny.

I do see where your coming from on the PE. If I understand correctly your saying a company has a distorted PE because it has invested large amounts of capital and this has decreased the earnings considerbly. Therefore the current snapshot of the eps is not accurate of what it will be in the future because the spending will decrease while the revenue will grow significantly higher and a stock with a pe of 50 really had a pe of 35. Is that what your saying?

I also agree that it is impossible to predict out 5 yrs let alone even 2 yrs. But I think with old economy companies it is much more reliable. In "Buffetology" Coke was suspose to sell around 45-50 based on information from 1988-1998. I checked the price the night that i read the book and coke was at 45.50. That to me shows a pretty reliable prediction. I tested this on a stock and I came with in a penny of earnings. So I think discounting future cash flows based on ROe, revenue, and eps can be done. But only on companies that have had a lot of stability behind them. So it will not work for the internet companies. But possibly price to sales ratio would be useful.

Anyway I'm rambling so to cut it short, I think you have some great ideas but you are way too intelligent to do what the street does. Even Peter Lynch said the street is extremely unreliable not because lack of intelligence but because of conflicts of interest and fear of ruffling feathers.

I look forward to more discussion. Afterall if we all agreed there would be know way to make money in the market. I am curious on your buy and sell strategies as well. If you don't mind sharing them. If not I understand but I am always interested in getting other people's opinions. Specifically once you find a good company what determines when you buy it and what determines when you sell it. And I assume you have completely different strategies for high growth vs blue chips like merck, pfizer etc.

Mathimatix, You mentioned in your last post Modern Portfolio Theory. If you are a firm believer in MPT, which is an outgrowth of the belief in Efficient Markets, then you would probably disagree with most of the people who frequent this page. The PEG ratio is unnecessary if one believes in perfectly efficient markets, since (under this belief) the stock price will always reflect any and all information available about a given stock. The debate you have going seems to be about market philosophy.

I'm no finance major, but it seems to me that arguing that any human endeavor can be perfect is irrational. There will always be stocks that are over-valued or undervalued. Think about it. How many people do you know who buy stock solely because they are popular? Hell, my father-in-law buys stocks based on tips he hears at work, seldom knowing what the company even does. Millions of buy and sell decisions are made every day that don't have anything to do with fundamentals. Maybe some guy has to pay the bills, or taxes, or whatever. In aggregate, these unrelated decisions must affect the market in some way. I think they cause stocks to be improperly valued. For the most part it's a stable equibrium, i.e. stocks do tend to seek a steady state near their "true" value.

The value of PEGs, then, is to help pick out the stocks that are undervalued. Of course, you must agree that undervalued means "priced lower than what the stock is worth when one takes into account future earnings estimates." Seems reasonable to me.

Anyone who relies solely on PEGs to value a stock is, of course, foolish (small f). But using it as yet another piece of the puzzle, in concert with a broad-based analysis of the company's fundamentals, and perhaps a discounted-free-cash-flow-to-the-firm (DFCFF) analysis, is truly Foolish (big F).

Hello GSJOf the gentlemen you mentioned I am only familiar with Buffet and Lynch (sounds like a restaurant!), besides Ben Graham of course.

Warren Buffet may or may not use beta, I have no idea. But Buffet is classified as a franchise buyer. This sort of investor is a relative rarity, simply because they are able to directly influence management as a result of having significant stockholdings to the level which allows them into board meetings. This type of investor also will only invest in businesses they believe they understand thoroughly. Other primary criteria are that the stock's valuation must be significantly depressed, and they are long-term buy and hold investors, in the real sense of the term.

Similarly, I have no idea whether Lynch uses beta to arrive at PE ratings.

What I am saying is that by using the PEG, a company which does not justify a PE in line with its EPS growth, will either tend to be seen as perpetually overvalued or undervalued, and this will not allocate investment efficiently. Anyone using the PEG must have come across stocks which are always overvalued for example, but continue to rise. As a result the user of the PEG has experienced what I have described.

I agree with you that stable companies are far more "reliable" as far as any predicting of cash flows are concerned, although even Coke makes mistakes. The price to sales ratio is far more reliable compared to the PE ratio. The PS is superior in various ways to the PE. It is less rigid and more flexible. It also requires the input of beta, and more input generally compared to the PE. The PS is actually a function of the net profit margin.

Discrimination against Internet companies is something I disagree with. I look upon companies as either earnings positive or negative. If it is earnings negative I would use cash flow to analyze them. But as I am a conservative investor, I prefer to stay away from companies which do not make a profit in the historical sense of the term.

Anyway I'm rambling so to cut it short, I think you have some great ideas but you are way too intelligent to do what the street does. Even Peter Lynch said the street isextremely unreliable not because lack of intelligence but because of conflicts of interest and fear of ruffling feathers.

I did not at all wish to convey that the "street" is the ultimate voice. There are however many highly skilled good people on Wall street. At the same time, I believe in the empowerment of the individual investor. The Internet has been tremendously beneficial. I think one of the greatest trends to emerge in the nineties is the rising power of the individual investor. And long may we all prosper.

You are correct, there is not only one way to make money in the market. Many people have made money without ever knowing about beta, and many have lost money knowing about beta. All I was seeking to do here was try and refine what I consider to be a rather simplistic and clumsy valuation measure.

Simply put, my buy strategy revolves around minimum trend parameters being sustained. For example: I prefer a company that exhibits a pre-tax return on equity of 15%. When I invest in stock I like to know the basic story behind what drives it as well. As long as the stock remains at least above my parameters and continues with its profitable trend, I am happy. If it changes in a way I think has fundamental significance I would sell.

For valuation purposes I prefer to use the PS rather than the PE ratio.

If I am permitted here, for you to see the way I think, I have a website at QuantIdeas.com.

A debate over market efficiency is not something I relish. It is a bit like trying to debate the abortion issue! But perhaps there is a bit of a simplistic view over the words "efficient markets". Market efficiency as I was taught, does not require that the market price be equal to fair value at every point in time. All it requires is that errors in the market price be unbiased, in other words, prices can be greater than or less than fair value as long as the deviations are random. I believe in the randomness of markets. I have yet to discover anyone who can predict tomorrows price or move with each day with any high probability of reliability.

Secondly, as deviations from fair value are random, then there is an equal probability that a stock will be over or undervalued at a point in time. Stocks with low PE ratios should be no more or less likely to be undervalued than those with high PE ratios. This refers directly back to my point on the clumsiness of the PEG, which with some work can be refined to a less clumsy measure.

I stop short of subscribing to the strong form of the EMH. This is because I have found it to be practically not quite so.

My use of beta may imply I subscribe adamantly to all forms of the EMH, but I use it as a risk measure input, rather than to reach the efficient portfolio frontier.

Many may well buy stocks simply because it is popular, but the overwhelming tendency will be towards a rational stock market. The fundamentals will out, they have the weight of intelligent funds in their favor. It is not for example, coincidence that the major tech companies are favored so.

Respectfully, I must say that you miss my point. The whole reason why I declare that the PEG is useless is because it assumes all stocks are created equal in the eyes of the investor. For example, it maintains that if two stocks grow at the same rate, then they ought to be valuated equally. This is simply not so.

Forecasting growth rates is no more reliable than basing valuations on current earnings. But that is another debate entirely.

Basing a stock price valuation on future earnings demands even further adjustment to the discount rate used to arrive at the PE ratio. The farther out a return is based the greater the risk.

You were only able to reduce the equation because you choose the very extraordinary 1 year case. The annualized growth rate is really given by the equation,G = 100*((EPS1/EPS0)^(1/n)-1) where n is the number of years of projected growth. You cannot simplify the equation as you did if n is different than 1. The case where n = 1 is an extremely special situation mathematically. To understand this, just try to simplify the equation in the case where n = 2. Why should the equation be valid for n = 1 but not for n = 2?

This also has practicle implications. What is the difference between company 2 and company 1? With #1 you will be "earning" $7 a share while with #2 you will be earning only $2 a share for the same $9 purchase. It will take #2 over 3 years to catch up with #1. How many companies can sustain a 100% growth in earnings for 3 years?

Forecasting growth rates is no more reliable than basing valuations on current earnings. But that is another debate entirely.

I would suggest it should be the topic, since the reliability of PEG depends on the reliability of both of those measures. The P/E ratio is intended to give a simplistic assessment of "current" value, while the growth rate is intended to improve that assessment by giving it a future context.

For YPEG, there is a study (by David Lipshutz) supporting its reliability. For example, check the addendum at:

The case where n = 1 is an extremely special situation mathematically.

Not all that special. As far as I know, there are only 3 cases -- 1-year, 2-year, and 5-year. In many cases, the 1st year estimate includes existing quarters, so the n = 2 case isn't really that special either. It may only be 15 months out, instead of 24 or more. And more companies have 1st-year future estimates than 2nd-year future estimates or 5-year growth estimates.

As I noted in another message, there is a study to support using a PEG based on the 5-year growth rates.

Why should the equation be valid for n = 1 but not for n = 2?

Because it is a different equation. Otherwise, I would argue the reverse -- why is 2-year PEG meaningful if the 1-year PEG is nonsense? As you noted, compounding is one reason, but compounding is more important at the 5-year level than the 2-year level.

And, obviously, compounding is more important for high growth rates than low growth rates. So a longer-term PEG will value high growth stocks more strongly than a shorter-term PEG.

So, which PEG is meaningful for which investing timeframe? If you use the 5-year growth rate, you could end up with a self-fulfiling prophecy that selects primarily high expectation growth stocks. Which probably increases the level of risk.

Could it be that we're trying to make the PEG do too much? It would be nice to have something that takes risk into account, but there are certainly other valuation methods that already do just that (e.g. the DFCFF analysis I mentioned in a previous post, a good explanation of which may be found in The Streetsmart Guide to Valuing a Stock). One of the things I like about the PEG is that it is simple to use and tells me one simple piece of information: is the stock over or undervalued based on analysts' earnings estimates? I can always take an in-depth look at the estimates themselves. Is the stock only covered by one analyst? Is there a large disparity between analysts? Does the stock consistently outperform expectations?

Wasn't there some book where they programmed a computer to calculate the meaning of the universe and it finally spit out the number eight? I don't want some formula that's going to give me eight. That doesn't mean anything to me. I will continue to do in-depth analyses of good growth companies. As a small part of those analyses, I will use the PEG. Call me simple-minded, that's just me.

Did you ever wonder why some stocks not only sport outlandish P/E ratios, but also high PEG ratios as well, and yet they seem to keep going up up up while all those so-called "Value Stocks" don't do anything? Are we riding the biggest bubble since that tulip thing I keep hearing about? Are we in the midst of irrational exhuberance, or is this for real?

Well, first of all, I would like to just say that the PEG ratio is a big bunch of bunk. Look at the chart below.

The PEG ratio for the chart is 1. But look at the difference just 5 years can make. The stock with a growth rate of 100% per year, assuming the stock price does not change, now has a P/E of 3.1. The stock with a 10% growth rate has a P/E of 6.2. Which stock would you rather buy today? Right! If you can find a company that is growing earnings at 100%, whose PEG ratio is 1, snap that bad boy up and hold on for dear life. A P/E of even 200 would get you a 5yr. P/E of 6.2. A PEG ratio of 10 or more would not be unreasonable for this stock (but you will lose money if it does not grow as expected). If you are looking for a bargain based on PEG ratio, you have already eliminated all the best growth stocks from your portfolio.

Okay, okay...PEG ratio is useful for comparing stocks with low P/E ratios and limited growth potential. However, for companies in the hypergrowth stage, it is misleading in the extreme.

You said: "A stock's valuation is reliant on beta because it is the only way to quantify its risk, and as of date is the accepted technique used in modern investment finance, in other words Wall street."

Thats true, but only if you believe Harry Markowitz, who invented the efficient portfolio theory. There has been a lot of (professional and academic) criticism of this model, and many people believe it simply does not hold up in reality, and if applied often actually underperforms the market.

The Beta comes from the Capital Assets Pricing Model (CAPM). It is indeed a much used model. But it has certain weaknesses as well. The CAPM model uses a number of assumptions, including;

-Unlimited shortsales are allowed.

-Borrowing and lending at the risk free rate are unrestricted.

-investors have homogeneous expectations.

-all assets are marketable.

-no market imperfections.

Furthermore there is a problem with Beta; it reflects market fluctuations in the past. When a beautiful and healthy company drops 75% in price, its Beta goes up ! Thereby making it a more risky asset, and a Beta oriented fund manager would therefore pass by this buring opportunity.

But do you really believe that a company becomes more risky because its price drops substantially ?

Lets use common sense here; potatoes usually trade at 1$ a kilo. If they drop to 20ct a kilo, does that make potatoes a more risky asset ? Is it riskier to buy potatoes at 20ct, than it is to buy them at 1$, when the underlying funhdamentals are the same ?

Beta does not look at the company. It only looks at the market price of an equity. And that is where it is flawed imho.

I determine the risk of a company by looking at its fundamentals. Earnings growth fluctuations for example provide me with a better instrument to determine the risk of a company. If earnings have been stable for many years, and free cashflow is stable, and growing, then the asset is less risky. When earnings fluctuate a lot, going from losses, into gains, into losses, that is simply a red flag, a no-buy criterion for me.

Another way to determine risk is to see how much future expectations the market has priced into an asset. You can do this by calculating the expectation risk index. If the price of an asset consists of 95% expectations, and 5% true value, then this points towards a risky company.

So in short: BETA captures the past, and not the future. An asset with a BETA of 0 has had minimal deviation from the index in the past. But that does not tell us anything about the future. This company may go bankrupt, or the market may punish its stock, or other circumstances may cause its price to fluctuate. Thereby altering the BETA as well, but by then its too late, because BETA was already used to establish a fair value.

There has been academic debate over the CAPM since the day it became the dominant model to quantify risk. Previously there was no model, and others such as the arbitrage pricing model (APM) are more complex and volatile. So until a superior model becomes available, then the CAPM is it.

Just like any model, the user's inputs determine the outputs. The upshot being that investors who try and use it in ways it was not meant for, and others who persistently obtain numbers that are unhelpful should rather look at their inputs of the models they use. The CAPM remember is only part of broader valuation equations based on the basic financial discount dividend model, which in turn is a derivative of the basis for all financial valuations, the present value model.

As for your pointed criticisms, calculating beta is not at all as rigid as you believe. The user can adjust the regression section, which is only part of beta as they please. Any outlier such as the 75% will be eliminated if desired. The other parts which calculate a company's specific beta are financial leverage and operational leverage, which depend again on the users definitions - albeit that there are standard accepted formulas.

The beauty of the CAPM is that it is VERSATILE and is not rigid. Rigidity in finance is a road to hell.

The price of a company is simply the outcome, it signifies something but declares nothing. Beta is most definitely wrapped up in the fundamentals of a company as my comment above indicates. You ask whether a company becomes more risky if it drops substantially, and my answer is it could - it depends why it has dropped. If a stock moves up the same way it also could portend greater risk. The reason will either be fundamental or unsystematic, leading to a new trend, or market related whereby the change is systematic.

Anyone who uses the CAPM is required to understand the quantitative nature of the company concerned, in other words the fundamentals - and they had better know security analysis well, otherwise the CAPM is not going to work for them. Remember all the CAPM is doing is quantifying the company's cost of capital or minimum return demanded by investors - but this is essential in order to calculate a company's PE or PS for example. The CAPM was accepted as a sweetener to his works by the father of security analysis Ben Graham. This is related in his biography.